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Seth Klarman Baupost Group: Margin of Safety and Type 2 Error Bias

Seth Klarman’s Baupost Group is the world’s 11th largest hedge fund. Seth Klarman is also the writer of a $1500 book, Margin of Safety, which reflects his views on investing. Klarman was fresh off of graduating from Harvard Business School when one of his professors, Bill Poorvu, asked him to help manage money. Poorvu and his partners, Howard Stevenson, Jordan Baruch and Isaac Auerbach, used their names to create the acronym, Baupost, that became the name of the company. Klarman’s name wasn’t included. Clearly when they hired Seth Klarman, they didn’t want to change the name of the fund to Baupostkl.


Baupost had an initial capital of $27 Million, which was a very large amount of money in 1982. The four founders were planning to split this capital among several money managers, but they literally couldn’t find other conservative money managers. So, SethKlarman was given all that money to manage. And when we say conservative, we really mean it. Seth A. Klarman published his book in 1991. Below we show Baupost Group’s annual returns for a 10-year period after the publication of his book. You may notice that Baupost Group underperformed the S&P 500 index by an average 2.4 percentage points per year during this time period. It even lost more than 18% between May 1998 and April 1999, indicating a significant screw up.

Baupost Group S&P 500
4/30/1992 9.5% 14.0%
4/30/1993 18.9% 9.2%
4/30/1994 13.4% 5.3%
4/30/1995 8.1% 17.5%
4/30/1996 13.1% 30.2%
4/30/1997 24.8% 25.1%
4/30/1998 30.0% 41.1%
4/30/1999 -18.3% 21.8%
4/30/2000 9.9% 10.1%
4/30/2001 27.1% -13.0%

Anybody can make mistakes. On the average Klarman’s Baupost Group was really conservatively managed. Seth Klarman explains this in detail in his  $1500 book, Margin of Safety. We like value investing. We also like investing with a margin of safety. However, the “Margin of Safety” concept has been unnecessarily glorified by value investors. There are two types of mistakes a fund manager makes. Taken from statistics jargon, type 1 mistake is buying a stock that underperforms. Type 2 mistake is not buying a stock that outperforms. Neither of these mistakes is good. Type 1 mistakes can be costly but being too conservative is also suboptimal.

Seth Klarman’s investors’ primary goal was preservation of capital and they managed to shape his investment philosophy for their own needs. They were totally OK with underperforming the market or leaving a lot of money on the table as long as they were certain that their money was invested really conservatively. One shouldn’t confuse being risk averse with being a great money manager. We don’t think Seth Klarman is a great money manager, but he’s at the top of our list of hedge fund managers to monkey. What’s key about following Seth Klarman is that you should pay attention to when he starts deploying a lot of capital.

Seth Klarman was very cautious before the 2008 crisis. However, in 2008 he suddenly became very eager to invest. He even raised additional capital from investors. He was early in investing and lost around 10% in 2008. Not a great return for a very conservatively managed hedge fund. However in 2009, Klarman returned 27% and during the first four months of 2010 he returned around 4-5%. 2009 has been one of the best periods for investors in recent history, yet Baupost returned only 27%. They were investing conservatively and that’s why they didn’t match David Tepper’s spectacular performance. That’s what we mean by a type 2 error bias. Managing money conservatively is a preference, not a virtue to be applauded. It’s like buying insurance. Seth Klarman keeps a lot of cash in his portfolio. We don’t know why an investor wants to pay some fund manager 2-and-20 for keeping 30-50% of his portfolio in cash. We wouldn’t.

We follow Seth Klarman’s moves as a general stock market indicator and also monkey his stock purchases when they make sense. He usually doesn’t invest in the stock market. At the end of September he had about $1.7 Billion worth of stocks in his portfolio, which is less than 10% of the $23 Billion he manages. When he buys stocks, which are riskier than his other investments are, there usually is a very good reason. Check out the 16 stocks Seth Klarman’s Baupost had at the end of September.

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